What Will Help The Economy?

Is Saving Bad for the Economy?

by Frank Shostak

[Posted June 21, 2001]

At the March meeting of the Fed’s Open Market Committee, officials expressed
concern that consumers might boost their savings, thereby weakening or even
aborting the economic expansion. Most economists concur with the view that
what keeps the economy going is consumption expenditure.

Furthermore, it is generally held that spending rather than individual
saving, is the essential condition for production and prosperity. Saving is
seen to be detrimental to economic activity as it weakens the potential
demand for goods and services.

Economic activity is depicted as a circular flow of money. Spending by one
individual becomes part of the earnings of another individual, and visa
versa. If however, people have become less confident about the future it is
held they will cut back on their outlays and hoard more money. So once an
individual spends less, this worsens the situation of some other individual,
who in turn also cuts his spending.

A vicious circle is in place – the decline in people’s confidence causes them
to spend less and to hoard more money. This lowers economic activity further,
thereby causing people to hoard more etc. The cure for this, it is argued, is
for the central bank to pump money. By putting more cash in people’s hands,
consumer confidence will increase, people will then spend more and the
circular flow of money will reassert itself.

All this sounds very appealing. Business activity show that during a
recession businesses emphasize lack of consumer demand as the major factor
behind their poor performances. Notwithstanding this, can demand by itself
generate economic growth? Note that this model says nothing about the
production of goods and services. Are we to take them for granted? Are they
always around and all that is required is demand for them?

In short, it would appear that what impedes economic prosperity is the
scarcity of demand. But is it possible for the general demand for goods and
services to be scarce?

At any point in time the amount of goods and services available are finite
this is not so with regard to people’s demand, which tends to be unlimited.
Most people want as many things as they can think of. What thwarts their
demand is the availability of means. Hence there can never be a problem with
demand as such, but with the means to accommodate demand.

Moreover, no producer is preoccupied with demand in general, but rather with
the demand for his particular goods. A baker is concerned with the demand for
his particular brand of bread. He is not preoccupied with the general demand
for bread, or the general demand for goods and services.

In the real world one has to become a producer before one can demand goods
and services. It is necessary to produce some useful goods that can be
exchanged for other goods.

For instance, when a baker produces bread, he doesn’t produce everything for
his own consumption. Most of the bread he produces is exchanged for the goods
and services of other producers, implying that through the production of
bread the baker exercises his demand for other goods. His demand is fully
covered i.e. funded by the bread that he has produced. Demand cannot stand by
itself and be independent, it is limited by prior production. It is the
production of bread that permits the baker to procure various goods and
services. Bread is a baker’s means of payment.

What limits the production growth of goods and services is the introduction
of better tools and machinery i.e. capital goods, which raises worker
productivity. Tools and machinery are not readily available; they must be
made. In order to make them, people must allocate consumer goods and services
that will sustain those individuals engaged in the production of tools and
machinery.

This allocation of consumer goods and services is what savings is all about.
Note that savings become possible once some individuals have agreed to
transfer some of their present goods to individuals that are engaged in the
production of tools and machinery. Obviously they do not transfer these goods
for free, but in return for a greater quantity of goods in the future.
According to Mises,

Production of goods ready for consumption requires the use of capital
goods, that is, of tools and of half-finished material. Capital comes into
existence by saving i.e., temporary abstention from consumption.

Since saving enables the production of capital goods, obviously saving is at
the heart of the economic growth that raises people's living standards. On
this Mises wrote,

Saving and the resulting accumulation of capital goods are at the beginning
of every attempt to improve the material condition of man; they are the
foundation of human civilization.

The introduction of money will not alter the essence of what saving is all
about. Money fulfils the role of a medium of exchange. It enables the produce
of one producer to be exchanged for the produce of another producer. Observe
that while money serves as the medium of exchange, it doesn’t produce goods
and services, it only enables goods and services to be exchanged i.e. it
allows a change of ownership to take place.

Also, it should be remembered that in the money economy the ultimate payment
is with real goods and services for other real goods and services. Thus a
baker exchanges his bread for money and then employs the obtained money to
buy other goods and services, implying that he pays with his bread for other
goods and services. Money only facilitates this payment.

Another important role of money is to serve as a medium of saving. Instead of
saving goods, which requires storing them, people can save money. In the
world of barter perishable goods are difficult to save for too long. These
difficulties are resolved by the money economy.

Once a producer has exchanged his goods for money he has in fact begun
saving. When a baker sells his bread for $1 to a shoemaker he has in fact
supplied the shoemaker with his saved i.e. unconsumed, bread. The supplied
bread will sustain the shoemaker and allow him to continue making shoes. Note
that money received by the baker is fully supported by his production. Being
the medium of exchange, money will enable the baker to secure goods and
services some time in the future, whenever he requires them.

Through money, people channel real savings, which permit economic activity to
take place. Thus the saving of money by one individual supports the
production of another individual, who in turn by exchanging his produce for
money, supports a third individual. Likewise, when a company issues stocks,
or bonds the money received for these financial instruments enables the
company to buy real savings i.e. goods and services, which in turn will
enable it to pursue planned objectives.

In this way money enables real savings to permeate across the economy and
lift the pace of production of goods and services. Contrary to popular
thinking saving doesn't weaken aggregate spending, on the contrary it
reinforces it. On this Henry Hazlitt in his "Economics in One Lesson" wrote,

When money is saved and then invested it is used to buy or build capital
goods. Any of these projects puts as much money into circulation and gives as
much employment as the same amount of money spent directly on consumption.
Saving in short in the modern world, is only another form of spending.

It doesn’t follow however, that one can lift economic growth and effective
real aggregate spending through the printing presses. When money is printed
i.e. created "out of thin air" by the central bank it sets in motion an
exchange of nothing for money and then money for something i.e. an exchange
of nothing for something. An exchange of nothing for something amounts to
consumption that is not supported by production.

Because every activity has to be funded it follows that an increase in
consumption that is not supported by production must divert funding from
wealth generating activities. This in turn diminishes the flow of real
savings to the producers of wealth, which weakens the flow of production i.e.
sets in motion an economic recession.

For instance, when money "out of thin air" gives rise to consumption that is
not supported by preceding production, it lowers the amount of funding that
supports the production of goods and services of the first wealth producer.
This in turn undermines his production of goods, thereby weakening his
effective demand for the goods of another wealth producer. The other producer
is in turn forced to curtail his production of goods thereby weakening his
effective demand for the goods of a third wealth producer. In this way money
"out of thin air", which destroys savings sets up the dynamics of the
consequent shrinkage of the production flow.

Observe that what has weakened the demand for goods is not a sudden
capricious behavior of consumers, but the monetary injections of the central
bank that have weakened the effective demand. In short, every dollar that was
created "out of thin air" amounts to a corresponding dissaving by that amount.

So long as the real pool of savings is expanding the central bank and gov
ernment officials can give the impression that loose monetary and fiscal
policies drive the economy, this illusion is shattered once the pool becomes
stagnant or declining.

Whilst savings are an important factor in fuelling economic growth, for them
to become effective they must be properly employed. On this Mises wrote,

Neither have capital or capital goods in themselves the power to raise the
productivity of natural resources and of human labor. Only if the fruits of
saving are wisely employed or invested, do they increase the output per unit
of the input of national resources and of labor. If this is not the case,
they are dissipated or wasted.

Furthermore, Mises wrote,

Without saving and successful endeavors to use the accumulated savings
wisely, there cannot be any question of a standard of living worthy of the
qualification human.

This sheds light on current events in Japan where the high savings rate that
has ranged between 15-20% is blamed for the economic slump. What is happening
in Japan is not the result of "too much saving" as suggested by many experts,
but rather of too many loose fiscal and monetary policies, that continue to
destroy whatever households are saving. The misguided policy of lowering
interest rates to almost nil is a major catalyst behind the destruction of
real savings.

By means of the artificial lowering of interest rates and monetary pumping
the Bank of Japan has been diverting real funding away from wealth generating
activities towards wealth consumers and in the process has significantly
weakened the potential for economic growth. Hence the only way to prevent the
current economic slump from developing into a galloping depression is to
abort the present loose fiscal and monetary stance. Furthermore, the size of
the government must be cut to the bone in order to enable the private sector
to channel savings towards wealth generating activities.

To conclude, what enables the expansion of the flow of production of goods
and services is savings and not demand. It is through savings, which give
rise to production, that demand for goods can be exercised. In short, no
effective demand can take place without prior production. If it were
otherwise then poverty in the world would have been eradicated a long time
ago.

After all, every individual aspires to have a good and comfortable life. What
always thwarts these aspirations are the means that have to be produced. Any
attempt to create an illusion that people's wishes somehow could be
accommodated through the monetary presses is sooner or later shattered by the
facts of reality, that it is not possible to get something out of nothing.

* * * * *

Frank Shostak, PhD, is a frequent contributor to Mises.org. Send him mail at
frank.e.shostak@ords.com.au. and see his outstanding Mises.org Archive.

See, by Ludwig von Mises: The Economic Role of Saving and Capital Goods
(1963); The Saver as a Voter (1957); The Outlook for Saving and Investment
(1966)

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